The excitement surrounding the Twitter IPO may have reignited some uncomfortable memories of the febrile technology markets at the turn of the century, but, argues Nick Evans, manager of the Polar Capital Global Technology fund, technology managers are operating in a fundamentally different world today.
In particular, he believes the technology market is in a pernicious and fast-moving stage of its development, likely to see incumbents dethroned and new tech heroes crowned.
This means initial appearances are deceiving. Twitter’s valuation, for example, looks high, but Evans says the winners in ‘big data’ – of which Twitter is a key example – are likely to see earnings in excess of the market’s current expectations. In contrast, incumbents such as IBM, Microsoft and Oracle look cheap and have strong balance sheets, but are facing fundamentals challenges to their business models that may see them move into structural decline unless they respond adequately.
Central to this is the shift from companies keeping and maintaining their own hardware, to moving to a rental model, using cloud computing.
Head in the clouds
Evans says: “IT budgets are barely growing. IT spending is moving from being considered capital expenditure to being considered operating expenditure.”
He believes there is an assumption that legacy businesses such as IBM will be beneficiaries of the uptick in US economic growth, when IT budgets have traditionally expanded, but this business is likely to go elsewhere in future.
“Some legacy technology stocks will be very negatively impacted by these changes – IBM, for example, or Oracle. Some, such as Microsoft, could well be impacted in the near future. That said, some new cycle companies are too expensive, but the winners will deliver stronger earnings than the market expects.”
He says the winners in technology rarely look cheap on normal metrics. The key is not to overpay and to ensure a company is likely to grow its earnings ahead of market expectations.
This is true for companies such as LinkedIn, Facebook or Tripadvisor, all of which feature in his portfolio. In general, he is prioritising companies that are beneficiaries of the move to cloud computing, mobile broadband and smart phone proliferation.
The Polar Capital Global Technology fund holds few of these declining megacap stocks. Evans says the fund had a tough period when these areas briefly moved back into favour, but believes they won’t be re-rated again. He says: “Technology is unique in that being the incumbent is usually a bad thing. They have most to lose when a newer, disruptive technology takes hold.”
Divide and conquer
This means that while Evans believes that it is a good time to be investing in technology, it is not for the reason many generalist investors are directing themselves towards the sector. The incumbents may look cheap, but they are cheap for a reason. Stocks in higher growth areas may look more expensive, but they are likely to prove to be more profitable in the long term.
“My conviction in the new cycle continues to grow,” he says. “The fundamentals between the incumbents and beneficiaries of the new cycle continue to diverge and while there may be times of mean reversion in markets, ultimately share prices will follow this divergence in fundamentals.”
Growth is Evans’ first priority when looking at a stock. The companies he holds in his portfolio display annual revenue growth of 21%, compared to 14% for the wider market. He believes revenue growth is a key driver of share price performance for technology companies.
Building stability
The aim is to build a ‘diversified portfolio of secular growth companies’. He sees value in meeting company management and will travel to do so, but also gets an audience with technology companies visiting London. The group remains the largest specialist technology manager in the UK and the second largest in Europe.
Evans manages or co-manages two funds – the £352m open-ended Polar Capital Global Technology fund and the £609.3m closed-ended Polar Capital Technology Trust. He says operating through two structures gives the team stability of assets in a sector that can be subject to erratic fund flows.
While the funds are global in approach, both have a significant weighting to the US – around two-thirds for both funds.
Evans’ approach is to tread a line between peers who either stick too close to the benchmark or are very aggressive and concentrated in the positions they take.
“We pay little attention to the benchmark, but we manage risk by not taking enormous bets,” he says. “The pace of innovation in technology is such that the dynamics of the sector can change quickly. This is why we don’t take big positions – 3% tends to be our maximum weighting.”
Forward thinking
In particular, the philosophy is to look forward rather than back. For example, until recently, Apple did not appear in the top 10 of the open-ended fund, despite it being a large weighting in the technology indices. The valuation needed to reflect that it may be going ‘ex-growth’ and might not be the powerhouse it has been in the past.
Evans believes the emphasis on looking forward rather than back is likely to be particularly important in the current environment where knowing the companies not to own will have a material impact on returns.
He says these phases in the technology market tend to occur every 10 years and are disruptive: “If you don’t understand the risks you tend to get sucked into companies that turn out to be value traps.”
The funds have no natural bias to large-, mid- or small-cap stocks. They have historically tended to be underweight the mega-cap stocks because of the incumbency problem, but are otherwise agnostic on size.
Evans says the smaller cap technology names tend to be less cyclical than the bigger companies and therefore there may be good and bad times to own more of that type of company.
Evans will not go below a market cap of $200m and is clear on the liquidity constraints of the fund. He says that using normal risk metrics, they have calculated they could liquidate 97% of the fund within five days and liquidity is always a consideration.
The technology boom and bust of 1999/2000 taught Evans to be cautious on valuations. Although his priority is always growth over value, he will sell out where he believes valuations have moved ahead of themselves.
The most recent example of this was Yelp, where he sold out after the share price had had a strong run.
Experience is everything
Evans joined Polar in 2007, having previously run a number of specialist technology mandates for Framlington. He previously ran the Axa Framlington global technology fund from 2001 to 2007. He started analysing technology stocks in 1998, so has built up 15 years worth of experience in the sector and lived through the crash of 2000.
The technology team at Polar is now six-strong and includes Ben Rogoff, who joined the group in 2003. He too has amassed around 15 years worth of experience in analysing technology stocks. Evans believes the group’s asset base and the experience of the team are key differentiating factors from their peer group. Rogoff is listed as the lead manager on the closed-ended fund, while Evans is focused on the open-ended fund.
The Global Technology Fund’s longer-term performance is strong. The fund is up 162.4%, compared to a return of 115.6% for the wider equity – tech media & telecom sector over five years. Its three year numbers are just below the sector average, a hiatus that Evans attributes to a brief resurgence for larger-cap technology stocks in which he had little weighting. The fund has resumed its outperformance over one year, and is up 29.7% against the sector average of 24.7%.
As might be expected from a growth mandate, the fund has historically done better at times of high returns for the technology sector. For example, it outpaced the sector significantly in 2009 and 2010, (by 16.3% and 16.8% respectively) but dipped more than the market in 2011, falling 13.1% compared to a sector average of 8.5%.
Evans is relatively bullish about the outlook for technology, believing that the macroeconomic environment is likely to provide support.
“The policy tightening in the US should provide a favourable backdrop for the technology sector. The set-up is looking compelling for 2014.”
The technology sector may be worth re-examination, but not because of its cheap, legacy companies, but because it has some of the highest growth stocks of the future.
